Another Year in Buffett’s House

Last year, when BRK [Berkshire Hathaway] reported their annual earnings with the letter, report, and 10K, I concluded:

From an earnings growth standpoint, there was nothing that amazing about the earnings in 2014. A few new subsidiaries like NV Energy added earnings, but existing subsidiaries’ earnings were flattish. Comprehensive income was considerably lower because of the lesser degree of unrealized appreciation on portfolio holdings.

On net, it was a subpar year for Berkshire Hathaway. The annual letter provided a lot of flash and dazzle, but 2014 was not a lot to write home about, and limits to the BRK business model with respect to float are becoming more visible.

What I said one year ago would be a good summary for this year, though Buffett was more upbeat about outcomes this year, with BRK’s book value advancing while the S&P 500 fell on a total return basis.

BRK is reducing reinsurance — i suspect they aren’t getting the rates that they want. There are too many reinsurance wannabes attempting to write business to generate float that they can invest against. Typically, writing insurance in order to invest usually doesn’t work out. People forget how much money was lost writing marginal insurance business in soft markets thinking they would more than make up the losses with investment income. BRK is showing some discipline here — good.

Aside from new lines of business (specialty insurance), growth is slowing; BRK is trying to remain a conservative underwriter.

Reserving conservatism has not changed.

Asbestos position has not materially changed.

GEICO had a bad year for claims — maybe they grew too much, and maybe picked up a lower class of auto driver.

Profit margins falling

Float growth slowing

Continued problems with workers’ comp and long-term care at Gen Re. Also problems with payment annuities (blames FX, should blame longevity) and Life Reinsurance.

A few quotes from the 10K on insurance issues:

“We define pre-tax catastrophe losses in excess of $100 million from a single event or series of related events as significant. In 2015, we recorded estimated losses of $136 million in connection with a property loss event in China.”

and on GEICO:

“Losses and loss adjustment expenses incurred in 2015 increased $2.7 billion (17.1%) over 2014. Claims frequencies (claim counts per exposure unit) in 2015 increased in all major coverages over 2014, including property damage and collision coverages (three to five percent range), bodily injury coverage (four to six percent range) and personal injury protection (PIP) coverage (one to two percent range). Average claims severities were also higher in 2015 for property damage and collision coverages (four to five percent range), bodily injury coverage (six to seven percent range) and PIP coverage (two to four percent range). We believe that increases in miles driven, repair costs (parts and labor) and medical costs, as well as weather conditions contributed to the increases in frequencies and severities.”

Regarding Gen Re:

“The property/casualty business generated pre-tax underwriting gains in 2015 of $944 million compared to $1.4 billion in 2014. In 2015, we incurred losses of $86 million from an explosion in Tianjin, China. There were no significant catastrophe losses in 2014. Underwriting results in 2015 included comparatively lower gains from property catastrophe reinsurance and the run off of prior years’ business.”

I found the mention of two large loss events in China interesting — maybe it was just one event of $136 million, but they could have been more clear.

Float Note

Before I leave the topic of insurance, I do want to set the record straight on how valuable float is. This is my best article on the topic. Buffett is a bit of a salesman in his annual letter, but generally an honest one.

Float is only as good as the insurance business generating it. If it is generating underwriting losses, the investments will have to earn at least as much per year as the losses divided by the average duration of how long the float will exist in years, in order to break even.

We’re coming off of years where there have been no underwriting losses, so float is magical — but the P&C insurance industry is getting more competitive, and float will no longer be costless.

Widespread use of float for financing is like trying to finance off of other seemingly costless liabilities — in the hands of some investors, that can lead to disaster — after all, consider all of the disasters that I have written about where people finance short to invest long.

Conservative insurers invest their premium reserves in cashlike instruments, and their loss reserves they invest in bonds of a similar duration. They typically don’t invest float in equities, and certainly not whole businesses.

Buffett has done just that and done well. That said, he runs his insurers at lower levels of leverage than most insurers, to allow room for taking more investment risk.

Note that BRK doesn’t guarantee the debts of BNSF, BHE, etc., but does guarantee the debts of the finance arms.

There is room for another article on float and cost of capital — not sure when I will get to it, but it will be a WACC-y article. ?

Final Notes:

1) Note that Buffett keeps profits overseas also. Quoting the 10K: “We have not established deferred income taxes on accumulated undistributed earnings of certain foreign subsidiaries. Such earnings were approximately $10.4 billion as of December 31, 2015 and are expected to remain reinvested indefinitely.” My guess is that he will use them to buy a foreign subsidiary.

2) BRK Pays taxes at about a 30% rate.

3) Regarding his comments on goodwill amortization — he thinks some of it is economically valid, and some not. Buffett has the option of putting more data on the income statement if he wants. Or put it in note 11 (goodwill). He already does that by breaking apart revenues and expenses by corporate divisions on the income statement. Do us all a favor, BRK, and split the goodwill into what you think is economically valid, and what is not.

4) Buffett gives an extended defense of Clayton Homes lending. In general, I thought his points were good — even before Buffett, Clayton was the “class act” in manufactured housing, and financing it.

5) Even BRK has underfunded pension plans, and it has a relatively conservative 6.5% expected return on assets.

6) I note a modest change in 10K risk factors — BNSF and the automatic braking issue. BNSF will have to spend a lot of money to deal with the need to stop runaway trains remotely. True of all US and Canadian railroads.

7) BRK has less free cash flow to invest in new projects because more of their businesses are capital-intensive. BRK invested $16B in property, plant and equipment.

8 ) BNSF had a good year. BH Energy had a good year, mostly from a new Canadian Transmission utility, and their home brokerage arm.

11) The big four publicly traded firms owned by BRK didn’t have a good year. AXP, KO, IBM, WFC — he bought more of IBM and WFC. Buffett argues that the retained earnings of the firms benefit BRK. I’m dubious. IBM has particularly been a dog — look at free cash flow. Much of the earnings at IBM aren’t real. You can’t use what they don’t dividend.

12) Quoting Buffett from his section on optimism about the US, he tempered it by saying: “Though the pie to be shared by the next generation will be far larger than today’s, how it will be divided will remain fiercely contentious.”

Well, you can say that again, but fairness is a squishy concept. Is fairness:

Even division (from each according to his ability, to each according to his needs)

Proportionate to productivity

Equal to what you negotiate

Derived from the formula of a bureaucrat

What you can negotiate through the political process

Impossible

Or something else?

Buffett worked with the easy stuff, and waved his hands at the hard stuff. I’ll phrase it this way: in general, the US has done well because we have not wrangled as much as the rest of the world over distribution issues, and have left a lot of room for people to gain a lot from their own productivity. That has led to a lot of wealth, and in general, a growing pie for everyone to benefit from.

Productivity goes in waves, and labor plays catchup with capital after technological progress. We have seen people redeployed from agriculture and servanthood/slavery in the past 150 years. We will see them redeployed from manufacturing in the next 100 years. They will provide services to their fellow men, should there continue to be peace and tranquility, allowing labor income to catch up with that of capital.